October 21, 2019

Reading Between the Minutes

Income Strategy 3Q 2019 Letter

The Income Strategy returned 2.69% (net of fees) in the third calendar quarter, outperforming the BofA Merrill Lynch High Yield Master II index’s 1.22% return. The Strategy ended the quarter ahead of its unmanaged benchmark year-to-date, but we always want to do better, and the past quarter and year are no exception. We have long attempted to create an income-generating portfolio with “negative duration,” meaning we believe the value of our holdings would rise if longer-term rates do. If we are able to achieve this dynamic, it should make the portfolio a compelling, but more volatile, complement to traditional fixed income portfolios, whose values tend to fall as inflation and rates rise. While the falling-rate and slowing-growth environment has been a challenge for us over the past year, we believe two recent macro inflections could represent big positive changes at the margin for our strategy – namely, more accommodative monetary and trade policy.

We have spilled no shortage of ink on the Federal Open Market Committee’s (FOMC) interest rate decisions for a variety of reasons. First, no other regularly changing policy is likely to have a greater impact on the economy and markets. Financial theory posits that the risk-free rate of interest is the basis upon which all other securities are priced. Second, it is also uniquely alterable, and the range of outcomes is relatively narrow, especially when compared to fiscal policy. We are not the only investors who view Fed policy as distinctively important, given that the official meeting record remains shrouded in secrecy until its release three weeks after each meeting. Computers and investors quickly analyze the release of the minutes, which often sends significant gyrations through trillion-dollar markets.

The major, explicit rate changes tend to occur during the FOMC’s regularly scheduled meetings, but we believe the most recent between-meeting policy change may have received less attention than deserved, representing a meaningful market inflection point, despite the Fed’s proactive denial of this premise. On October 8, FOMC Chair Jerome Powell communicated that The Fed will soon start buying $60B per month of short-term Treasury bills, which comes on the heels of not only slowing global growth but also major stresses in short-term funding markets, which have seen troubling signs of tight liquidity in the form of rate spikes. The decision to start new asset purchases completes a U-turn on the marginal trajectory of monetary policy over the past two years; systemic liquidity is now on the upswing. Prior to these just-announced asset purchases, the central bank’s assets peaked at the beginning of 2015 and had been essentially constant for three years until the balance sheet normalization program began at the end of 2017 and picked up pace through 2018, causing the Federal Reserve’s assets to fall by 15% between the end of 2018 and the August 2019 asset trough, at which point funding markets forced the Fed’s hand to be more aggressive in providing liquidity.

So, the monetary policymakers at the most important central bank in the world are now back to a wholly accommodative stance at least through the second quarter of 2020, via both additional asset purchases as well as an inclination to continue lowering their target rate (n.b., the Fed lowers its target rate through conducting open market operations, which just means they buy bonds). Now, there may be another potential key inflection on the horizon, which could come from a trade deal with China. If one assumes President Trump wants another term in office, the market has told him repeatedly that making nice with China matters. Still, it would not be fair to expect a deal to materialize overnight between the world’s two largest economies, representing 40% of global GDP. There will be ongoing puts and takes, but it would not be unreasonable to assume that some type of deal is likely prior to the next election, which would be a boon for global growth prospects. If we are right, all of this would augur well for our strategy, which focuses on what we believe to be undervalued yield.

We typically use these letters to focus more on the thought process behind the changes to the portfolio than we have in this letter, mainly because we view the recent portfolio changes as less significant than the potential macro shifts we just discussed, but we will touch on the thought process behind the more significant recent moves. We eliminated our position in Blackstone (BX) near $50/share versus an average cost of approximately $34 with some nice dividends clipped along the way. We have written extensively about the alternative asset managers and continue to hold big positions in both Apollo (APO) and Carlyle (CG), mainly because we view their valuations as much less demanding relative to their prospects when compared to Blackstone. We also eliminated our position in the General Electric perpetual preferreds near a ten-point premium to our average cost. Not everything we sold was a winner. We cut our losses on the mall REIT Washington Prime Group (WPG), which continues to struggle. While the management team is working hard to fight the ongoing secular shifts, they may prove too strong to overcome. We also eliminated the Ascena bank loan, which lost money for us, as we failed to anticipate how poor management’s execution would be.

The most significant new position is the debt of private prison operator GEO Group, whose yield is at an all-time high, approaching 11% annualized if one believes the bonds will be repaid at par. Longer-term shareholders will recall that we are no strangers to the space, as we purchased GEO equity in 2016 near its all-time low after the Obama administration announced it intended to phase out the use of private prisons. A quick review of the situation back then showed that a) the federal government had less direct influence over contracts than the market thought, and b) there were few readily available alternatives. There are several interesting aspects to the more recent sell-off. Despite the debt market’s angst hitting at an all-time high, the only plan in place that could affect the group is the recently signed California legislation preventing contract renewals starting next year. GEO Group owns most of the space for which it is responsible in the state, and presumably, California would need to pay GEO for those facilities; the headline risk is likely greater than the real risk, which is where the opportunity lies.

The aforementioned bonds are just one of many ideas that we find compelling in the current environment, and we are on the hunt daily. Please feel free to contact us with any questions, comments or ideas. As always, we remain the largest investors in the Strategy, and we appreciate your support.

Bill Miller IV, CFA, CMT

Strategy Highlights by Tyler Grason, CFA

Top Contributors

National CineMedia (NCMI) was the top contributor over the quarter, rising 28.23%. The company reported Q2 revenue of $110.2M, just shy of consensus of $113.0M driven by weaker-than-expected June attendance. Operating Income Before Depreciation and Amortization (OIBDA) of $50.2M was in-line with street estimates, and the quarterly dividend of $0.17/share maintained (8.2% annualized yield). Management reaffirmed full-year guidance with revenue of $450M-$465M and OIBDA of $207M-$217M. Lastly, the company announced an amendment in their Exhibitor Services Agreement, allowing the shift of ads into the trailer window ahead of a film’s start which should drive additional in-theatre ad demand with incremental revenue and OIBDA.

Carlyle Group (CG) advanced 15.21% during the period after reporting core distributable earnings of $0.35, just below consensus of $0.37. Fee-related earnings of $133M topped estimates while net realized performance revenues were lower than expected at $21M. Assets Under Management (AUM) of $222.7B came in +55 basis points sequentially with net accrued carry +5% to $1.9B. Management announced plans to convert to a C-corp effective January 1st, 2020 and move to a single share class structure that will pay $1.00/share in fixed annual dividends (3.9% annualized yield).

Quad/Graphics (QUAD) rose 37.07% over the quarter after posting Q2 Earnings Per Share (EPS) of $(0.09), beating estimates of $(0.17) on better-than-expected revenues of $1.0B against estimates of $975M. The company maintained its $0.30/share quarterly dividend (11.4% annualized yield). Management reaffirmed full-year guidance where they see revenues of $4.05B-$4.25B, Earnings Before Income, Taxes, Depreciation and Amortization (EBITDA) of $360M-$400M, and free cash flow of $145M-$185M. The company also announced they have mutually agreed to terminate their merger with LSC Communications (LKSD), stating added delay and legal cost uncertainty would have likely eroded a considerable amount of the expected synergies from the deal.

Top Detractors

Just Energy Group (JE) was the top detractor over the quarter falling 44.23%. The company reported EBITDA of C$24M (USD $18M), missing consensus of C$39M (USD $30M) on lower-than-expected revenues and announced a suspension to the dividend while the strategic review remains ongoing. Management lowered full-year EBITDA guidance to C$180M-C$200M (USD $137M-$152M) from C$220M-C$240M (USD $168M-$183M) and free cash flow to C$50M-C$70M (USD $38M-$53M) from C$90M-C$100M (USD $69M-$76M).

Chaparral Energy 8.75s of 2023 fell 33.71% during the period despite strong Q2 results with total production of 28.3 million barrels oil equivalent per day (Mboe/d), beating consensus of 27.5 Mboe/d and guidance of 26.0-27.5 Mboe/d. EBITDA of $43.7M (+54% sequentially and +62% year-over-year) topped estimates of $42.5M. Management maintained full-year production guidance of 25.0-27.0 Mboe/d, lowered capital expenditure (capex) guidance to $260M-$285M (from $275M-$300M), announced a General and Administrative (G&A) cost reduction initiative of 20%-25%, and noted they are on track to free-cash-flow neutrality by the back half of 2020. Lastly, the company announced their creditors reaffirmed their $325M borrowing base and amended their credit facility to provide a restricted payments carve-out of $30M to repurchase debt.

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Past performance is no guarantee of future results. For important additional information on Income Strategy performance, please click on the Income Strategy GIPS Composite Disclosure. This additional information applies to such performance for all time periods.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.